A new model for Europe's economy

Commentary

With last week's tumult in Italian markets, the European financial crisis has entered a new and far more dangerous phase, threatening both European monetary integration and the global recovery.

Last week's drama surrounding bond auctions in Europe's third-leading economy should convince even the most hardened bureaucrat that the world can no longer let policy responses be shaped by dogma, bureaucratic agenda and expediency.

It is to be hoped that European officials can engineer a decisive change in direction, but if not, the world can no longer afford the deference that the International Monetary Fund and non-European Group of 20 officials have shown European policymakers the past 15 months.

Three realities must be recognized if there is to be a chance of success.

• First, systemic confidence is essential in a financial crisis. Teaching investors a lesson is a wish, not a policy. U.S. policymakers were applauded for about 12 hours for their willingness to let Lehman Brothers go bankrupt.

  The shattering consequences that had on confidence are still being felt.

  The European Central Bank is right that punishing creditors for the sake of teaching lessons or building political support is reckless in a system that depends on confidence.

  Those who let Lehman go believed that because time had passed since the Bear Stearns bailout, the market had learned and so was prepared.

  In fact, the main lessons learned had to do with how to best find the exits, and uncontrolled bankruptcies had systemic consequences that far exceeded their expectations.

  • Second, no country can be expected to generate huge primary surpluses for long periods for the benefit of foreign creditors. Meeting debt burdens at rates the official sector, let alone the private sector, is charging for credit would involve burdens on Greece, Ireland and Portugal comparable to the reparations' burdens that John Maynard Keynes warned about in "The Economic Consequences of the Peace."
    • Third, whether or not a country is solvent depends not just on its debt burdens and its commitment to strong domestic policies but on the broader economic context. Liquidity problems left unattended become confidence problems. Debtors who are credibly highly solvent at interest rates close to or below their nominal growth rates become insolvent at higher interest rates, putting further pressure on rates, exacerbating solvency worries in a vicious cycle. This has happened in Greece, Portugal and Ireland; it is in danger of happening in Italy and Spain.

      European authorities must restate their commitment to solidarity as embodied in a common currency and the recognition that the failure of any European economy means the failure of the European economy and is unacceptable. Interest rates for program countries must be reduced; there is no reason to charge a risk premium, which needlessly threatens the success of the whole enterprise, when failure is unacceptable. Countries whose borrowing rate exceeds a certain threshold should be exempted from contribution requirements for bailout funds. Countries judged to be pursuing sound policies should be permitted to buy EU guarantees on new debt issuances at a reasonable price payable on a deferred basis. These measures would reduce payments for debtor nations and assure confidence in the stability of European banks.